Austerity Strikes Back

The tale of the hard-working North vs the lazy South has been cited again and again during the past couple of years, mostly from Northern politicians who saw the on-going crisis as an opportunity to promote their own agendas. At the core of this "argument" was the self-assuring conviction that "we do not need them (the South), they need us". Through an array of measures mostly aimed at austerity in order for state financials to regain their vigor, the North is surprised at the increasing debt-to-GDP ratio in the short-run and is accusing some of the South for not pushing through enough reforms.

As has been explained before, when GDP goes down, debt has to decrease by much more in order for the debt-to-GDP ratio to remain constant. Yet, this will obviously not be the case as the economy contracts much faster than the GDP can be reduced. In addition, when policies are based on austerity, results are usually much harsher for citizens than when they are not. Even though many have failed to see it at the time of implementation, austerity measures in the periphery also affect the North. The simple rationale behind this is that the North was (until now) basically exporting while the South was largely importing goods; the heavy reliance on each other was more than evident as in 2010, no country in the Eurozone had less than a 57% share of intra-EU exports.

Yet, many continued to think that a heavy reliance on exports was a sign of a "vibrant economy" which would lead to higher wages and higher domestic demand. The brief answer is a big fat no. You see, the issue here is that heavy reliance on exports means heavy reliance on the well-being of your neighbours; if your neighbours are poor it means that they buy much less from you than if they were rich. Simply put, reliance on exports means that if they go down, they take you down with them. 

The issue is not new. Some of us have already discussed this in detail, and warned that this situation cannot go on forever. We were (unfortunately for the citizens of the North which are not to blame for the mistakes of their governments) correct. The latest data show something quite startling: Retail trade in December 2013, the month which generally signals the peak in consumer spending, has decreased by 1.6%, compared to November.

In monthly terms, Portugal and Spain were the leaders in the drop, although this did not come as a surprise. The "surprise" is that Germany, Austria, Belgium and Finland have also seen a sharp drop in retail spending. What is even more astonishing is that on a year-to-year basis,  Germany, Belgium and Finland lead the race in the drop. As if this wasn't enough bad news, the bank de-leveraging procedure which has been going on in the periphery appears to have started in the North as well. Germany, Austria and France saw total bank loans to non-financial corporation reduced by 1%, 1.1% and 1.5% respectively, and even if this is not large compared to what happened in the periphery (and Slovenia with the extraordinary 23.8%) it is indicative of the worsening situation in the region.

As a result of de-leveraging and the decrease in spending, inflation in the Eurozone has dropped to 0.7% on an annual basis. Even though just 4 out of 28 countries experience deflation, the rest are barely above 1%; only Austria is close to the ECB mandate of 2%.

North's problem can be reduced to two simple words: no demand. You see, as others also note as well, while banks are not currently in a large need for de-leveraging and are more than willing to lend their excess funds, they cannot do it in their domestic markets as people, in contrast to what most monetary authorities would suggest, are not willing to borrow even at near-zero rates. Less borrowing means less spending, or in economic terms less demand. This results in deflation, which in its turn ends up being a self-perpetuating situation (unless this is stopped as Irving Fisher noted in 1933). As consumption comprises more than 2/3's of GDP, output falls when consumption is reduced.

The situation has begun evolving in Finland where output decreased by 1.1% in November 2013 compared to the previous year, with the same thing occurring in October 2013. The 0.4% contribution to GDP growth led by net exports in the country in 2012, is unlikely to be repeated until demand in the South picks up. With the main forces of the decrease in the 2013 GDP being domestic demand and inventories (both driven by consumption and demand) the path appears to be same as Germany where net exports are expected to take growth down with them in 2014. Even though the country's trade balance has also fallen in December, the effect of local demand, which fell by 1.6% has taken its toll in factory orders in the last month of 2013.

As the gains from trade are not translated into higher domestic demand (either by credit or directly), these have to be tunneled somewhere: housing prices in Germany have soared by at least 25% (in some cases more than 35%) since 2008. The Lehman story has taught us that housing bubbles are not a good thing; actually Deutsche should remember its experience better. With the rest of the Eurozone decreasing imports and domestic demand where does the North expect to ship that 20% of GDP in intra-Eurozone exports and how is it going to sustain the level of GDP currently obtained if domestic demand is also shrinking?

The German Export Beast

It appears that the US have been critical of Germany's attitude towards exports. Basically, the US, now backed by the IMF, are critical of the German Chancellor's claim that exports indicate a healthy economy. Although I disagree with Merkel's claim for the pure reason that an export-based economy is basically relying on others to prosper, I cannot help but cast my doubts on the stance many have taken against Germany.

My regular readers will certainly know that I am not a friend of German policy on most subjects. Still, I find it rather odd that a country which is having trouble with too much imports and is actually trying to decrease its current account deficit is trying to support that another country shouldn't have a large current account surplus. To be honest, I find it rather hypocritical, especially from the IMF's point of view. The fund’s First Deputy Managing Director David Lipton urged Germany to "lift its sights to the global horizon" and that cutting excessive deficits in the euro area “simply can’t happen unless surpluses are down as well.” 

Maybe Lipton is right and maybe Merkel should pay attention to what he is saying. Still, what was his employer doing when they organized the bail-out of 5 Eurozone countries in past 5 years? Simply, they were creating the situation that Germany is currently "exploiting": high uncertainty, low competitiveness, high unemployment and most importantly a depreciated euro. I will not delve into whether Germany had a say in all those or not; it is irrelevant to the role the IMF played. The IMF is supposedly an independent organization which assists ailing nations with or without the assistance of others. In any case, the IMF has supposedly been independent and unbiased in both its estimations and its opinions.

Yet, where was this opinion when the Irish bail-out was orchestrated? Or how about the Spanish or Portuguese or Greek or Cypriot one? Did the IMF change its stance on the subject as time passed on? This is an article from last February commenting on what the Washington Post published as Olivier Blanchard's mea culpa on the IMF policies in Greece. Yet, the directors never changed their tune and did the same in Cyprus just a month later. Now, they are basically blaming Germany for taking advantage of a situation they have created. But is it just Germany though or is it a general trend in the Eurozone surplus? Eurostat data favour the latter view: Euro-Area trade surplus increased to 7.1 billion in August 2013, compared to 4.6 billion in August 2012 (which was not just because of the North surpluses). 

There are those of course who are not taking a like to the US stance on the subject. FT's Gideon Rachman comments "If you had to single out a major Western economy whose irresponsible economic policy has posed a persistent danger to the global economy, the obvious candidate would be the United States." His points are correct all the way. The Great Recession alone supports his view, and if we wanted we could easily find more (the Great Depression for example). QE has been a drag on both the US and the world economy for long now and stories about whether the Fed should taper or not (or whether it can) are a major cause of uncertainty, without the officials doing anything about it. In addition, if we are to pin-point, why just Germany? China and Japan have been doing the same for years yet there has been no criticism of their actions (other than the one for the remnibi's "constant" depreciation).

Others though still think that Germany is, in their words, "a weight on the world". The arguments Wolf makes are correct and the risk of permanent deflation exists in the periphery. I doubt whether such a scenario would occur in reality, yet I think the probability exists and deflation in 2014 is something we can expect. Is Germany employing a beggar-thy-neighbour policy? To be honest, I doubt whether it can. Germany can earn significant amounts from exporting heavily, yet this comes at a cost: inflation in Germany as current data show is at 1.7% thus far, slightly higher than the EA average of 1.6%. 

Is this increase significant? Perhaps not, but the inflation monster so feared by Germany might prove too hard to kill given the ECB rate cut and the increased probability that the rest of the Eurozone recovers. As Evans-Pritchard puts it, the ECB is ready to print and Germany is ready to scream; he also rightly points out that a bout of deflation in Italy is much more severe than a bout of inflation in Germany. My take is that the ECB will finally move the way it should. Although the rate cut was much ado over (almost) nothing, it was a step towards the right direction, mainly to boost inflation in Germany and the North and investment and consumption everywhere else.

In any case, arguments like "the Germans do not work as hard as they think" (which Matt Yglesias makes) are really unnecessary and I remember deconstructing them more than a year ago. The US exports as much as Germany Matt states, but forgets to mention that the former's GDP is more than 4 times larger than the latter's and its population approximately 4 times as much, meaning that imports will be (and are) much higher and the current account will be negative. Yet, that is not a problem for the US since it has a sovereign currency of its own. Germany and the rest of the Eurozone do not. As he again points out the proposal is one to "buy more foreign-made goods and services." But these all depend on their cost and how they fare with German products. And let's face it: German products are (usually) of great quality.

Thus, as deflation sets in the rest of the Eurozone in 2014, prices in Germany will rise as a result of exports, making goods from other Eurozone countries look more appealing. This will help both the periphery countries increase their exports and Germany reduce it's dependence on foreigners (i.e. reduce exports) with the additional effect of appreciating the euro. The bottom line is that high exports are not a sign of a healthy economy, they are a sign of dependence on foreign factors. Still, blaming a country for high exports when you cannot control your own or when you were at large the culprit for the creating of the situation which allows them to pursue such policies does not make sense at all.

The Effects of Recession on German Exports

Let's admit it. Germany one of the most well-off nations in Europe at the moment. The monetary value of its exports rank it as the second country in the world after China. Yet, although it has been mentioned that Germany has been lucky to have demand for its products rise due to emerging economies the data might suggest something different. In total Germany exported goods values about €1.061 trillion in 2011. Here is the list of the top 20 country to which Germany has exported goods:

Source: Statistischess Bundesamt, Wiesbaden.

As you may France, the Netherlands, Italy, Belgium and Spain account for about €350 billion of German exports. Why did I just select these countries? Well, France's economy is at the brink of recession, with zero growth over the last two quarters, Belgium has already initiated austerity programs and has seen its GDP contract by 0.2% last quarter and the Netherlands have just resurfaced from recession. And the reasons are obvious for Italy and Spain. (second quarter data can be found here)

Even if we just measure the most distressed nations in the Union (Greece, Spain, Italy, Portugal, Cyprus and Ireland) the total amount of exports to those nations is €112 billion, more than 10% of total exports.

The above graph shows the percentage of intra-EU and extra-EU trade per country. As you may see, about 60-65% of Germany's exports are within the EU. The only nations which have a high percentage of non-EU exports are Greece, Italy and the UK.

What is my point here? That when recession hits a nations, the first thing that falls is imports. And to nations who depend on each other for imports and exports, this is of tremendous importance. Imagine what would happen if suddenly all 6 of the above nations saw demand for foreign goods collapse (and need I remind you that with the possible exception of Ireland we are talking about countries who are producing and exporting great amounts of food and cheap clothing so we can assume that they are importing goods whose demand is elastic, i.e. can vary according to price or buying power) then Germany will lose a vast amount of its trade. And when this happens then I am sure that France and Belgium will be the next places where demand for imports will fall as well.

I do believe that Europe is now facing its own Great Depression. As no measures have been taken, it would be easy to see that an EU-wide recession will eventually set up. Although Germany now has a very strong economy, as so do the Scandinavian nations, the correlations between nations are so strong that one severe recession in one country can cause a domino effect. Time will indeed show...

Conspiracy Theories and the Eurozone

I do not like conspiracy theories. To be really honest I hate them. I believe that conspiracy theorists are those kinds of people who do not want to take responsibility for their actions (or their government’s actions) and think that this is all part of a massive hidden elaborate plan devised by -insert nation here- to control/take over their homeland’s economy/natural resources or whatever. Thus, anything they will do will be futile; all they can do is blame the one "responsible" for this as they sit around and do nothing. This kind of thinking I truly, honestly hate. 

However, lately I have been thinking about one. I am not proud to say it but I have. It all started when I began thinking about what they could do instead of the large haircut on Greek debt last year. If that haircut had not taken place the only country that would have been in direct danger from Greece would have been Cyprus, due to the explosive growth of its banks there. And even Cyprus wouldn't have been so worried then. Read more here.

What I have been thinking was this: Let's assume that policymakers in Eurozone are not stupid. Let's assume that what they have been doing has some rational reason hidden behind it. What were the consequences of their actions and who would benefit from that?

The first direct consequence would have been the fall of the value of the Euro. The following graph indicates this trend for the EUR/USD pair. (Graph was made by Yahoo!Finance)

As one may observe the value of the Euro versus that of the US dollar has declined dramatically of the past year and a half. Thus, it would mean that European products are now cheaper than they were 1.5years ago. Thus, more exports. This can be seen by the following graph (made by www.tradingeconomics.com)

As we can see exports began to rise after February 2010 and continue to rise to this day. (An examination of most EU countries individually would confirm this but to be honest I am bored to upload and comment on 20 graphs! I am sure you would be bored to read one article like that too.)

Thus the only conclusion we may draw was that the EU policymakers are deliberately keeping the EUR/any other currency rate down so as to export more. Any good news about the Euro economy would have as a result an increase in the rate and thus decrease exports. Thus the conspiracy theory would be that policymakers want to flood the world with EU goods (or maybe just German goods for obvious reasons. Wolfgang are you there?) and make us rich by large trading surplus; however not now but in a few years. It's a merchants world after all!

Or, they just make bad decisions. What do you think?